Why interest rates should rise now

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November 2, 2017 by Paul Goldsmith

Economies work in cycles. Yes yes I know Gordon a Brown said he had abolished Boom and Bust, but in truth, economies will at the very least have growth and recession, and it can’t be too long before we have the next recession. It is for this reason that, whilst they still have the time, the Bank of England monetary policy committee are right to be considering raising interest rates.

The Bank of England ‘base rate’ feel from 5% in early 2008 to 0.5% later that year. It stayed that low until 2016, when it was cut once more to 0.25%. In one sense, this has been good for borrowers, be they individuals or businesses or governments, as the cost of borrowing money has been at an all time low. But this has led personal debt to rise again to the £1.6trn,with over £200bn of that in overdrafts, credit cards, unsecured personal loans and car loans. This is near where it was before the last financial crisis. Add that to an inflation rate that has moved up past 3% (over the Bank’s target, which is to keep it between 1 and 3%) and you have good reason to start tightening monetary policy.

Furthermore, it would not be a bad thing to give some encouragement to people to save a bit more, in order to make sure they are in a better position if the economy starts to downturn. Raising interest rates increase returns on savings and investments, so that might work, too.

However, some might worry that the Bank of England could be causing that recession to happen by raising interest rates. Mood music out of Threadneedle Street is that the plan is to very gradually raise rates up to perhaps around 3%. This could, by reducing the incentive to borrow in order to fund consumption or investment, and increasing the incentive to save, which again reduced consumption, itself cause a slowdown in the economy.

In answer to this, the Bank of England produces, every quarter, an Inflation report, setting out detailed economic analysis from its agents around the country and feeding that into prospects for inflation. Whilst the premier objective of the Monetary Policy Committee (MPC) has is to keep inflation within the target, there are also secondary objectives around economic growth and unemployment. It has, at its fingertips, sufficient information to make its decisions, and, if the plan is to slowly raise interest rates now, then one must assumes it believes it can do that without harming economic growth much, if at all.

Some are linking the decision to raise interest rates with the inflation rate rising. That is relatively a red herring, although it is not completely irrelevant. There are two categories of cause of inflation rising. One is called ‘demand-pull’, caused by an increase in consumption, investment, Government spending, or net exports. The other is called ‘cost-push’, caused by a rise in costs for businesses, feeding through to price rises. The Pound has fallen in value but the value of exports hasn’t risen that much, for a variety of reasons. The value of imports HAS risen, simply because raw materials are now more expensive and the UK has no option but to import them. The key point is that the MPC raising interest rates can affect demand-.pull inflation but not cost-push inflation.

The more important long-term reason for the rise in interest rates is to give The Bank of England back the ability to use monetary policy again. Interest rates have been so low that quantitative easing (QE – printing money) has had to be the only tool available in the past seven or eight years. If the interest rate gets up to around 3% then when the economic cycle next turns southward (and it will), the MPC will have the option to use interest rates to try and slow down any recession, which they don’t really have now.

QE is highly inflationary, because money is being produced without any concurrent production taking place. Fiscal policy (manipulation of government spending and taxation) can be used in a recession as well, but can cause further deficit and debt problems. Lowering interest rates can have an almost unique mix of short term and long term benefits, because the borrowing that might take place can increase both aggregate demand (planned spending) in the short-run AND aggregate supply (productive capacity) in the future.

In truth, it will be combination of policies that help the country when we have our next recession, but it will also take a careful raising of interest rates now, whilst the sun is (relatively) shining, that will enable that combination of policies to be used.

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